Has Financial Development Made the World Riskier?

Transcription

1 Has Financial Development Made the World Riskier? Raghuram G. Rajan Introduction In the last 30 years, financial systems around the world have undergone revolutionary change. People can borrow greater amounts at cheaper rates than ever before, invest in a multitude of instruments catering to every possible profile of risk and return, and share risks with strangers from across the globe. Have these undoubted benefits come at a cost? How concerned should central bankers and financial system supervisors be, and what can they do about it? These are the issues examined in this paper. Consider the main forces that have been at work in altering the financial landscape. Technical change has reduced the cost of communication and computation, as well as the cost of acquiring, processing, and storing information. One very important aspect of technical change has been academic research and commercial development. Techniques ranging from financial engineering to portfolio optimization, from securitization to credit scoring, are now widely used. Deregulation has removed artificial barriers preventing entry, or competition between products, institutions, markets, and jurisdictions. Finally, the process of institutional change has created new entities within the financial sector 313

2 314 Raghuram G. Rajan such as private equity firms and hedge funds, as well as new political, legal, and regulatory arrangements. These changes have altered the nature of the typical transaction in the financial sector, making it more arm s length and allowing broader participation. Financial markets have expanded and become deeper. The broad participation has allowed risks to be more widely spread throughout the economy. While this phenomenon has been termed disintermediation because it involves moving away from traditional bank-centered ties, the term is a misnomer. Though in a number of industrialized countries individuals do not deposit a significant portion of their savings directly in banks any more, they invest indirectly in the market via mutual funds, insurance companies, and pension funds, and indirectly in firms via (indirect) investments in venture capital funds, hedge funds, and other forms of private equity. The managers of these financial institutions, whom I shall call investment managers have displaced banks and reintermediated themselves between individuals and markets. What about banks themselves? While banks can now sell much of the risk associated with the plain-vanilla transactions they originate, such as mortgages, off their balance sheets, they have to retain a portion, typically the first losses. Moreover, they now focus far more on transactions where they have a comparative advantage, typically transactions where explicit contracts are hard to specify or where the consequences need to be hedged by trading in the market. In short, as the plain-vanilla transaction becomes more liquid and amenable to being transacted in the market, banks are moving on to more illiquid transactions. Competition forces them to flirt continuously with the limits of illiquidity. The expansion in the variety of intermediaries and financial transactions has major benefits, including reducing the transactions costs of investing, expanding access to capital, allowing more diverse opinions to be expressed in the marketplace, and allowing better risk

3 Has Financial Development Made the World Riskier? 315 sharing. However, it has potential downsides, which I will explore in this paper. This focus is not meant to minimize the enormous upsides that have been explored elsewhere (see, for example, Rajan and Zingales, 2003, or Shiller, 2003), or to suggest a reversion to the days of bank-dominated systems with limited competition, risk sharing, and choice. Instead, it is to draw attention to a potential source of concern and explore ways the system can be made to work better. My main concern has to do with incentives. Any form of intermediation introduces a layer of management between the investor and the investment. A key question is how aligned are the incentives of managers with investors, and what distortions are created by misalignment? I will argue in this paper that the changes in the financial sector have altered managerial incentives, which in turn have altered the nature of risks undertaken by the system, with some potential for distortions. In the 1950s and 1960s, banks dominated financial systems. Bank managers were paid a largely fixed salary. Given that regulation kept competition muted, there was no need for shareholders to offer managers strong performance incentives (and such incentives may even have been detrimental, as it would have tempted bank managers to reach out for risk). The main check on bank managers making bad investment decisions was the bank s fragile capital structure (and possibly supervisors). If bank management displayed incompetence or knavery, depositors would get jittery and possibly run. The threat of this extreme penalty, coupled with the limited upside from salaries that were not buoyed by stock or options compensation, combined to make bankers extremely conservative. This served depositors well since their capital was safe, while shareholders, who enjoyed a steady rent because of the limited competition, were also happy. Of course, depositors and borrowers had little choice, so the whole system was very inefficient. In the new, deregulated, competitive environment, investment managers cannot be provided the same staid incentives as bank

4 316 Raghuram G. Rajan managers of yore. Because they have to have the incentive to search for good investments, their compensation has to be sensitive to investment returns, especially returns relative to their competitors. Furthermore, new investors are attracted by high returns. Dissatisfied investors can take their money elsewhere, but they do so with substantial inertia. Since compensation is also typically related to assets under management, the movement of investors further modulates the relationship between returns and compensation. Therefore, the incentive structure of investment managers today differs from the incentive structure of bank managers of the past in two important ways. First, the way compensation relates to returns implies there is typically less downside and more upside from generating investment returns. Managers, therefore, have greater incentive to take risk. 1 Second, their performance relative to other peer managers matters, either because it is directly embedded in their compensation, or because investors exit or enter funds on that basis. The knowledge that managers are being evaluated against others can induce superior performance, but also a variety of perverse behavior. One is the incentive to take risk that is concealed from investors since risk and return are related, the manager then looks as if he outperforms peers given the risk he takes. Typically, the kinds of risks that can be concealed most easily, given the requirement of periodic reporting, are risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks. A second form of perverse behavior is the incentive to herd with other investment managers on investment choices because herding provides insurance the manager will not underperform his peers. Herd behavior can move asset prices away from fundamentals. Both behaviors can reinforce each other during an asset price boom, when investment managers are willing to bear the low-probability tail

5 Has Financial Development Made the World Riskier? 317 risk that asset prices will revert to fundamentals abruptly, and the knowledge that many of their peers are herding on this risk gives them comfort that they will not underperform significantly if boom turns to bust. An environment of low interest rates following a period of high rates is particularly problematic, for not only does the incentive of some participants to search for yield go up, but also asset prices are given the initial impetus, which can lead to an upward spiral, creating the conditions for a sharp and messy realignment. Will banks add to this behavior or restrain it? The compensation of bank managers, while not so tightly tied to returns, has not remained uninfluenced by competitive pressures. Banks make returns both by originating risks and by bearing them. As plain-vanilla risks can be moved off bank balance sheets into the balance sheets of investment managers, banks have an incentive to originate more of them. Thus, they will tend to feed rather than restrain the appetite for risk. However, banks cannot sell all risks. They often have to bear the most complicated and volatile portion of the risks they originate, so even though some risk has been moved off bank balance sheets, balance sheets have been reloaded with fresh, more complicated risks. In fact, the data suggest that despite a deepening of financial markets, banks may not be any safer than in the past. Moreover, the risk they now bear is a small (though perhaps the most volatile) tip of an iceberg of risk they have created. But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized. Past episodes indicate that banks have played this role successfully. However, there is no assurance they will continue to be able to play the role. In particular, banks have been able to provide liquidity in the past, in part because their sound balance sheets have allowed them to attract the available spare liquidity in the market. However, banks today also require liquid markets to hedge some of the risks associated with complicated products they have created, or guarantees they have offered. Their greater

6 318 Raghuram G. Rajan reliance on market liquidity can make their balance sheets more suspect in times of crisis, making them less able to provide the liquidity assurance that they have provided in the past. Taken together, these trends suggest that even though there are far more participants today able to absorb risk, the financial risks that are being created by the system are indeed greater. 2 And even though there should theoretically be a diversity of opinion and actions by participants, and a greater capacity to absorb the risk, competition and compensation may induce more correlation in behavior than desirable. While it is hard to be categorical about anything as complex as the modern financial system, it is possible these developments may create more financial-sector-induced procyclicality than the past. They also may create a greater (albeit still small) probability of a catastrophic meltdown. What can policymakers do? While all interventions can create their own unforeseen consequences, these risks have to be weighed against the costs of doing nothing and hoping that somehow markets will deal with these concerns. I offer some reasons why markets may not get it right, though, of course, there should be no presumption that regulators will. More study is clearly needed to estimate the magnitude of the concerns raised in this paper. If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions, especially if conclusive analysis is likely to take a long time. At the very least, the concerns I raise imply monetary policy should be informed by the effect it has on incentives, and the potential for greater procyclicality of the system. Also, bank credit and other monetary indicators may no longer be sufficient statistics for the quantity of finance-fueled activity. I discuss some implications for the conduct of monetary policy. Equally important in addressing perverse behavior are prudential norms. The prudential net may have to be cast wider than simply

7 Has Financial Development Made the World Riskier? 319 around commercial or investment banks. Furthermore, while I think capital regulation or disclosure can help in some circumstances, they may not be the best instruments to deal with the concerns I raise. In particular, while disclosure is useful when financial positions are simple and static, it is less useful when positions are complex and dynamic. Ultimately, however, if problems stem from distorted incentives, the least interventionist solution might involve aligning incentives. Investors typically force a lengthening of horizons of their managers by requiring them to invest some fraction of their personal wealth in the assets they manage. Some similar market-friendly way of ensuring personal capital is at stake could be contemplated, and I discuss the pros and cons of some approaches to incentive alignment. The rest of this paper is as follows. In the second section, I start by describing the forces that have driven the changes. In the third section, I discuss how financial transactions have been changed, and in the fourth section, how this may have changed the nature of financial risk taking. In the fifth section, I discuss potential policy responses, and then I conclude. The forces driving change Technology Technology has altered many aspects of financial transactions. In the area of lending, for instance, information on firms and individuals from a variety of centralized sources such as Dun and Bradstreet is now widely available. The increased availability of reliable, timely information has allowed loan officers to cut down on their own monitoring. While, undoubtedly, some soft information that is hard to collect and communicate direct judgments of character, for example is no longer captured when the loan officer ceases to make regular visits to the firm, it may be more than compensated by the sheer volume and timeliness of hard information that is now available. Moreover, because it is hard information past credit record, accounting data, etc. the information now can be automatically processed,

8 320 Raghuram G. Rajan eliminating many tedious and costly transactions. Technology has therefore allowed more arm s length finance and therefore expanded overall access to finance. Such methods undoubtedly increase the productivity of lending, reduce costs, and thus expand access and competition. Petersen and Rajan (2002) find that the distance between lenders and borrowers has increased over time in the United States, and the extent to which this phenomenon occurs in a region is explained by an increase in the bank-loan-to-bank-employee ratio in that region, a crude proxy for the increase in productivity as a result of automation. Deregulation and institutional change Technology has spurred deregulation and competition. In the 1970s, the United States had anticompetitive state banking laws. Some states did not allow banks to open more than one branch. Many states also debarred out-of-state banks from opening branches. Banks were small, risky, and inefficient. The reason, quite simply, for these laws was to ensure that competition between banks was limited so that existing instate banks could remain profitable and fill state coffers. As information technology improved the ability of banks to lend and borrow from customers at a distance, however, competition from out-of-state financial institutions increased, even though they had no in-state branches. Local politicians could not stamp out this competition since they had no jurisdiction over it. Rather than seeing their small, inefficient, local champions being overwhelmed by outsiders, they eliminated the regulations limiting branching (see Kroszner and Strahan, 1999). Thus, technology helped spur deregulation, which in turn created a larger market in which technologies could be utilized, creating further technological advances. Both forces have come together to spur institutional change. For example, not only has there been an enormous amount of bank consolidation, but also the activities of

9 Has Financial Development Made the World Riskier? 321 large banks have undergone change. As deregulation has increased competition for the best borrowers, and shaved margins from offering plain-vanilla products to these customers, large banks have reached out to nontraditional customers, or to traditional customers with innovative products. Taken together, all these changes have had beneficial, real effects, increasing lending, entrepreneurship, and growth rates of GDP, while reducing costs of financial transactions (see Jayaratne and Strahan, 1996, 1998, and Black and Strahan, 2001). Such developments can be seen throughout the world. Let me now turn to how they have changed the nature of interaction in the financial sector and, in the third section, how they may have altered the nature of risks. How financial transactions have changed Arm s length transactions or disintermediation A number of financial transactions have moved from being embedded in a long-term relationship between a client and a financial institution to being conducted at arm s length in a market. In many parts of the world where banking has been the mainstay, arm s length corporate bond markets and equity markets have expanded relative to the more stable private credit markets. While long-term relationships do lead to greater understanding and trust between parties, they do constrain each party s choices. Increasingly, only the most complicated, innovative, or risky financial transactions are embedded in relationships I will have more to say on this shortly. Greater availability of public information (not just about the client but also about the outcome of the transaction and the behavior of each party), the standardization of financial contracts, and the ability of financial institutions to carve up streams of cash flows (both contingent and actual) into desirable portions have contributed to this process of commodification of financial transactions. Consider each of these.

10 322 Raghuram G. Rajan The publicly available credit history of a potential borrower not only expands the set of potential lenders who can screen the borrower, but also serves as a punishment for those borrowers who default by significantly raising the cost and limiting access to future credit. Credit histories are now collateral. Of course, public information does not constrain just borrowers, it also constrains lenders. Large financial institutions dealing with the public are closely scrutinized by the press. They cannot afford to be tainted by unsavory practices. In turn, this knowledge gives retail customers the confidence to enter freely into transactions with these financial institutions. The standardization of contractual terms allows a loan to be packaged with other contracts and sold as a diversified bundle to passive investors who do not have origination capability. Alternatively, the cash flows from the bundle can be carved up or tranched into different securities, differing in liquidity, maturity, contingency, and risk, each of which appeals to a particular clientele. 3 This process of securitization allows for specialization in financial markets those who have specific capabilities in originating financial transactions can be different from those who ultimately hold the risk. 4 Securitization, thus, allows the use of both the skills and the risk-bearing capacity of the economy to the fullest extent possible. While the collection of data on the growth of the credit derivatives and credit default swaps in the last several years is still in early stages and probably underestimates their usage, the takeoff of this market is a testament to how financial innovation has been used to spread traditional risks (see Chart 1). Integration of markets The growth of arm s length transactions, as well as the attendant fall in regulatory barriers to the flow of capital across markets, has led to greater integration between markets. As Chart 2 suggests, the gross external assets held by countries (claims of citizens on foreigners) has grown seven-fold over the last three decades.

12 324 Raghuram G. Rajan The advantages of interlinked markets are many. With pools of capital from all over the world becoming available, transactions no longer depend as much on the availability of local liquidity but on global liquidity. A world interest rate is now close to a reality, with capital flowing to where returns seem the most attractive. In a seminal paper in 1980, Feldstein and Horioka pointed out that there seemed to be a much closer correlation between a country s savings and its investment than might be suggested by the existence of global capital markets national investment seemed to be constrained by national savings. The correlation between savings and investment rates within each region has fallen off, dropping from an average of 0.6 in the period to 0.4 in the period (see IMF, 2005b, World Economic Outlook, forthcoming, fall 2005). Reintermediation That more financial transactions are conducted at arm s length does not mean that intermediaries will disappear. For one, intermediation can reduce the costs of investing for the client, even if the relationship between the client and the investment manager is purely arm s length. Reintermediation is given further impetus as the sheer complexity of financial instruments and the volume of information about them increases investors prefer delegating to a specialist. Transparent institutions, such as mutual funds or pension funds, save transactions costs for investors. Less-transparent institutions, such as venture capital funds or hedge funds, have emerged to search for returns in newer, more exotic areas, as excess returns in more traditional investments have been competed away. Thus, for example, even as equity markets have grown, the share of direct investment by households in markets has fallen off in the United States (see Chart 3). Banking relationships in origination, product customization, and innovation As more and more financial products migrate to markets, and more transactions are undertaken at arm s length, are commercial banks (and

13 Has Financial Development Made the World Riskier? 325 Chart 3 Ownership of Corporate Equities in the United States (In percent of Total Market Value) Other Institutions Life Insurance Companies State and Local Pension Funds Private Pension Funds Foreign Sector Mutual Funds Households and Nonprofit Organizations Source: U.S. Flow of Funds their increasingly close cousins, investment banks) becoming redundant? To understand the role banks play, we need to understand the special nature of their capital structure and the relationships they build. The role of banks Traditionally, a bank has been defined in terms of its twin functions lending to difficult credits and offering demand deposits, or more generally, payment services. Yet these functions seem contradictory. Why offer depositors liquidity on demand when assets are tied up in illiquid bank loans? Does narrow banking not make more sense, where money market funds invested in liquid securities offer demand deposits while finance companies funded through long-term liabilities make loans? Calls for breaking up the bank resurface every few years (see, for example, Simons, 1948, and Bryan, 1988). Yet the form of the banking organization has remained virtually unchanged over a thousand years, suggesting some rationale for the organizational form. Diamond and Rajan (2001a) argue that it is the

14 326 Raghuram G. Rajan credibility obtained from the fragile capital structure that allows the bank to take on the risks associated with illiquid loans. If the bank mismanages funds, it knows it will be shut down in a trice by its depositors and counterparts in the money and inter-bank markets. It has a very strong incentive to be careful. Since this is widely known and understood, the bank will be trusted by the money market, other banks, and depositors. Its continued access to liquidity then enables it to provide it on demand to those who desire it. 5 Risk transfer Abstracting further to make this discussion more relevant to an industrial economy, the purpose of the bank is to warehouse risks that only it can manage, while financing with a capital structure that gives its management credibility. This means that if some risks become more vanilla and capable of being offloaded to the rest of the financial sector, the banking system will offload them and replace them with more complicated risks, which pay more and better utilize its distinct warehousing capabilities. After all, investment managers, who have a relatively focused and transparent investment strategy, have a lower cost of capital in financing liquid assets and plain-vanilla risks than banks, whose strategies and balance sheets are more opaque (see Myers and Rajan, 1998). 6 Consider an example. A fixed rate bank loan to a large corporate client has a number of embedded risks, such as the risk that interest rates will rise, reducing the present value of future repayments and the risk that the client firm will default. There is no reason the bank should hold on to interest rate risk. Why not offload it to an insurance company or a pension fund that is looking for fixed income flows? Increasingly, default risk is also being transferred. 7 However, the bank may, want to hold on to some of the default risk, both to signal the quality of the risk to potential buyers, and to signal it will continue monitoring the firm, coaxing it to reduce default risk. The lower the credit quality of the firm, the stronger the role of the bank in monitoring and controlling default risk, as also the greater the need

15 Has Financial Development Made the World Riskier? 327 to signal to buyers. Hence, the size of the first-loss position the bank retains is likely to increase as the credit quality of the loan falls (see Franke and Krahnen, 2005, for evidence). Thus, risk transfer, through loan and default risk sales, does not completely eliminate risk from bank balance sheets. In fact, bank earnings variability in the United States has not fallen (see Chart 4), and average bank distance to default in a number of countries has not increased (see Chart 5). It is apparent that banks have not become safer despite the development of financial markets and despite being better capitalized than in the past. In fact, they may have well become riskier in some countries. Finally, if we think bank earnings are likely to grow at the rate at which market earnings will grow over the foreseeable future, the declining price-earnings ratio of banks in the United States relative to the market suggest that the market is discounting bank earnings with an increasing risk premium (see Chart 6). This again suggests bank earnings have not become less risky. Instead of reducing bank risk, risk transfer allows the bank to concentrate on risks so that it has a comparative advantage in managing, making optimal use of its capital while hiving off the rest to those who have a natural appetite for it or to those with balance sheets large enough or transparent enough to absorb those risks passively. It also implies that the risk held on the balance sheet is only the tip of an iceberg of risk that is being created. Innovation and customization Apart from originating traditional products, banks also have a role in creating new products. The range of financial needs far exceed the range of financial products that are traded on exchanges. Customized over-the-counter products cannot always be created simply by mixing and matching existing exchange-traded instruments. Instead, banks have to create products tailored to specific client needs.

16 328 Raghuram G. Rajan Chart 4 S&P 1500 Banks: Earnings Volatilty Sample Average of Estimated AR(1)-Process Residuals All banks with some missing data Smaller sample without missing data Sample Average of Rolling Three-Year Standard Deviations of Estimated AR(1)-Process Residuals All banks with some missing data Smaller sample without missing data Notes: The residual is obtained from regressing annual bank earnings against lagged earnings. In the top panel, each residual is normalized by dividing by the average for that bank across the entire time frame then averaged across banks in the same period. In the bottom panel, a rolling standard deviation of the residuals is computed for each bank and then averaged across banks.

17 Has Financial Development Made the World Riskier? 329 Chart 5 Bank Distance to Default and Trend Component United States Canada Germany France United Kingdom 20 Netherlands Source: Datastream and IMF staff estimates

18 330 Raghuram G. Rajan Chart 6 S&P 500 Banks: Price-to-Earnings Ratios (In percent of S&P 500 P/E Ratios) Source: Datastream If there is sufficient demand on both sides for a customized product, it may make sense to eventually let it trade on an exchange. Before that, however, glitches have to be ironed out. New financial contracts will not be immediately accepted in the market because the uncertainties surrounding their functioning cannot be resolved by arm s length participants, who neither have money nor goodwill to spare. For instance, a key uncertainty for a credit default swap is what determines the event of default. Is it sufficient that the borrower miss a payment? Will a late payment on an electricity bill or a refusal to pay a supplier because of a dispute over quality suffice to trigger default? Will a negotiated out-of-court rescheduling of debt constitute default? These are the kinds of issues that are best settled through experience. If a bank offers the contract to large clients with whom it has a relationship, the unforeseen contingencies that arise can be dealt with amicably in an environment where both parties to the contract are willing to compromise because they value the relationship (this is not to say the occasional dispute will not end in court). Only when contractual features have been modified to address most contingencies can consideration be given to trading the contract on an exchange. Thus, banks are

19 Has Financial Development Made the World Riskier? 331 critical to the process of customization and financial innovation, using their relationships and reputations to test-drive new contracts. Sometimes the ambiguities in contracts can never be resolved, so the contracts do not migrate to the markets. Take, for instance, a loan commitment that is, a contract through which a bank agrees to lend at a pre-specified rate if the client demands a loan. Many loan commitments have an escape clause, termed the material adverse change clause. This allows the institution to duck the commitment if there is a material adverse change in the client s condition, a feature that protects the bank from having to make loans in circumstances where they clearly would not be repaid. In turn, this allows the bank to offer cheaper loan commitments. Of course, the loan commitment would mean little if the bank could renege with impunity. Every time an institution invokes the clause without adequate cause, however, its reputation will suffer a bit, and its future commitments will be worth less. This gives it the incentive to invoke the material adverse change clause only in the most necessary circumstances, and the credibility to offer a plausible commitment. Banks, unlike markets, can offer incomplete contracts (see Boot, Greenbaum, and Thakor, 1993, and Rajan, 1998). Finally, there are contracts for which there is only demand on one side. In such cases, banks may be willing to create the necessary contracts, offer them to clients, and hedge the ensuing risks, often through dynamic trading strategies in financial markets. 8 This last point suggests that in addition to its traditional role in offering liquidity to clients and the market, banks now also rely on the liquidity of all sorts of other markets to keep themselves fully hedged. We will return to the risks this poses later. Summary Let me summarize. Technical change, regulatory change, and institutional change have combined to make arm s length transactions more feasible. More transactions are now done on markets, as well as by institutions that have an arm s length relationship with their clients.

20 332 Raghuram G. Rajan This has not, however, marginalized traditional institutions like banks and their relationships. The changes have allowed such institutions to focus on their core business of customization and financial innovation, as well as risk management. As a consequence, the risks borne by traditional institutions have not become any lower. However, now new risks are spread more widely in the economy, and traditionally excluded groups have benefited. Are financial systems safer? I have outlined a number of changes to the nature of financial transactions. While these have created undoubted benefits and on net are likely to have made us significantly better off, they have opened up new vulnerabilities, to which I now turn. Let me start by pointing out some vulnerabilities created by the greater reliance of economies on arm s length transactions and markets. I then will turn to changes in incentives of financial sector managers, which will be my main focus. Greater demand on markets Markets have become more integrated, have drawn in a greater variety of participants, and, as a result, usually have more depth. Yet the demands made of these markets are not static and typically increase over time. One reason is that, with the exception of one-time spot deals, arm s length transactions rely enormously on the superstructure of the market on trustworthy and timely dissemination of public information, on reliable performance by counterparties (failing which parties expect rapid and just enforcement), on the smooth functioning of the payments and settlements system, and on the availability of reasonable exit options when needed that is, the availability of liquidity.

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